Can I expect to pull out all of my cash investment into an HMO conversion project by refinancing at a commercial valuation within a short period of time? We went myth busting last week, when we discussed the ability to recycle cash through property investing. Last time out we discussed buying a property and then seeking to refinance later on to extract all or most of our cash investment. Our conclusion was that for standard properties the best way of doing this quickly was to add genuine value to the property. But that is not the only way to do this, which is the subject of today’s discussion as we look at trying to release our cash by changing the basis under which a property is valued.
The HMO report produced by Shawbrook Bank, which includes a reference to four different classes of HMO, or contact us for a copy.
Today’s must do’s
Refinancing your HMO conversion project and expecting a 10x the annual rent revaluation...best have a listen / read to this week's show I suggest! Whilst it has been done, a far more likely outcome would be a revaluation multiple in the region of 7x or 8x the gross annual rent. However, there are lots of exceptions that could send this multiple up or down, so make sure you fully understand your project before you go too far into in...and the lender / valuer's likely opinion of the likely end-value above all else.
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Transcription of the show
Hello and welcome to another edition of The Property Voice Podcast, my name is Richard Brown and as always it is a pleasure to have you join me again on the show today.
OK, so we went myth busting last week, when we discussed the ability to recycle cash through property investing. Last time out we discussed buying a property and then seeking to refinance later on to extract all or most of our cash investment. Our conclusion was that for standard properties the best way of doing this quickly was to add genuine value to the property and not simply try to cash in on an apparently stellar discount from similar properties.
But that is not the only way to do this, which is the subject of today’s discussion as we look at trying to release our cash by changing the basis under which a property is valued…on with the show then.
If you remember, a couple of weeks ago I came across a number of people that were asking about recycling their cash investment in property deals.
Last week, we answered the question of whether an investor could reasonably expect to recycle their cash investment quickly when buying at a discount known as BMV or below market value
Whilst, I don’t wish to repeat and regurgitate that episode here and now, the conclusion was: no, not really…it would be better to add some genuine value and then try to refinance instead. Check that particular episode out for the longer version response to that!
The second question around recycling our cash investment that I recently came across was this:
“Commercial valuations on HMO: What's the 'real' info on valuations/financing without the course selling hype?”
Or to reframe the question in the context of our discussion today:
Can I expect to pull out all of my cash investment into an HMO conversion project by refinancing at a commercial valuation within a short period of time?
Before going too far into this topic, I thought I would address the point about ‘course-selling hype’ that was mentioned in the question posed. I could easily have left it out, however, I think it is a very important point to bring into the open.
I often hear of people, with a very clear vested interest claim that HMOs are a great way to extract all of our cash investment funds. These people may be sellers of courses or deal packagers, so they have a very clear benefit in making people believe this claim. I often hear the statement that you can get a house revalued at ten times the gross rental income in such situations.
I am tempted to say this is utter crap, but here is my more considered response.
First, how is this possible?
Well, the general principle is indeed a valid one. Property can be valued in several different ways and if you want to know what these are, then take a look at a guest post from Damien Fogg on The Property Voice blog, which I will reference in the show notes.
However, the main two valuation methods to concern ourselves with here specifically today are:
The comparable value method, which is also known as the bricks and mortar value; and
The investment method, which is often referred to as a commercial valuation.
The comparable value method is one we are likely to be the most familiar with as it most often applies to residential property, be it to live in or as a buy-to-let.
Essentially, the valuer will assess the property’s value by comparing it with a number of the most recent sales of similar properties in the immediate local area.
Good comparisons will be similar properties sold in the same sort of condition, within the last 6 months and within a quarter of a mile radius of the property being valued. The larger the number of suitable comparables, the better chance the valuer has of valuing it accurately and the crucially more confident they can be.
Of course, if there are not many suitable comparable properties available to benchmark against, then the valuer is likely to be cautious in their assessment. This in part explains why high density urban property valuations are often more reliable and consistent that those in less well populated areas such as small towns and villages.
The investment method relies on a property being valued as an investment property rather than as a residential property and is very common with commercial property like shops, offices and properties like that. The value is derived by the terms of the lease and especially the lease rentals, among a few other important factors.
HMOs are a hybrid type of property. On the one hand they are clearly residential as people will typically live there as their main or permanent home. However, they are also more like a small commercial premises in so far as they are let out by the room rather than as a single property unit and often have other services attached to them, such as providing furnishings, utilities and broadband, cleaning, gardening and such like.
This opens up an opportunity to get it valued on a multiple of its rental income in a similar was that shops and offices might be.
However, there is no clear definition of an HMO by the Royal Institute of Chartered Surveyors, or RICS, in what is known as their ‘Red Book’, which is the guide to valuing a property. As a result of this, each valuer will often make their own assessment of how they will value the property.
Add to this the fact that different lenders also have a different view of whether an HMO is a commercial or residential property and we can begin to see how some uncertainty around achieving an investment value can arise.
However, if an investment value is used, it is often based on what is known as the ‘local yield’ in that area. There are usually different yields across different parts of the country. These are based on the actual rents being achieved there compared to local property values.
Valuers tend to work out both the gross and net yield valuation figures and then plumb for the lower of the two. The gross yield is used to calculate the value before any deductions are taken out. Whereas, the net yield will often deduct utility bills from the rental income before it is used.
In many cases, a valuer will also stipulate the bricks and mortar, or comparable value in their report as well. So, we could end up with three or more different valuation figures in the same valuation survey, which I have seen a couple of times myself.
To illustrate, I have an HMO in where the local yields were stated as 13.5% gross and 10.5% net. Most of the local valuers will know this information and it is supposed to provide some consistency. The gross rent is around £34,000 per year.
To put this into valuation numbers, this would value this particular HMO at £254,000 using the gross yield investment method or £267,000 using the net yield investment method.
I actually paid £175,000 for the property and spent around £50,000 converting it into quite a high-end finish with en suites and kitchenettes.
So, you could say that the bricks and mortar or comparable method valuation method might be £225,000 if the total cost of the upgrade was taken into account, or simply a lower figure of say £175,000 plus a little extra, as it is now in decent nick. If it were valued as a standard house like the next-door neighbour, then it could be worth say £200,000.
Actually, that’s a fourth different valuation possibility isn’t it now?
And therein lies some of the confusion with valuing this and other HMO properties, I have just given you 4 different valuations that could be applied to the very same property, so which one is the right one and which one will be used?
£267,000, £254,000, £225,000 or £200,000?
The first two are variations of the investment method or a commercial valuation and the latter two are variations of a bricks and mortar or comparable method of valuation. There is a 33% difference between the highest and lowest valuation here, which would be very significant in our quest to recycle our cash.
Actually, it can get even more complex than that, but it’s probably best to leave it as just pretty complex rather than utterly mind-boggling for now at least!
The answer then, of which is the right valuation is: is depends…yes, that phrase again!
It depends on…
The extent of works
How much like a standard residential property it still appears to be
Article 4 restrictions
…and so on and so on.
In an attempt to add some clarity to the differences between one HMO and another, the lender Shawbrook Bank, released some information on the subject. They categorised HMOs into four distinct groups, following similar principles to those that I have just outlined. I will add a link to this in the show notes for you to check out later.
However, if you have ever tried to get an HMO valuation, you will notice that not all lenders would define an HMO in the same ways that Shawbrook does. Even if they did, the visiting valuer could apply their own take on the subject, given that there is not the equivalent in the Red Book as mentioned. I know, it’s very confusing isn’t it?
OK, so back to my example.
You will also note that none of the valuations in this example equated to ten times the gross rental income figure of around £34,000 a year or a valuation of £340,000. You may have clocked that 75% of £340,000 would be enough to fully recycle pretty much all of my cash costs if it were the case. But I am not trying to sell you a course on 100% cash recycling through HMOs either… J
The gross income method is equivalent to around 7.5 times the annual rental income. I have seen investment multiples at around this sort of level a few times, but also some around 6 times annual rent and very, very rarely up at the 10 times rent level. The net income multiple is a respectable 9.6 times the rent, but don’t forget that’s after deducting an allowance for bills to be paid.
At this stage, it is also worth highlighting that in some locations, such as London say, a bricks and mortar value could in fact be higher than an investment valuation as well…however that is perhaps over complicating things right now, so we will let that idea soak for another time.
The bottom line in this scenario is to try and get the investment valuation as high as possible such that when the property is refinanced a 75% loan will be sufficient to release enough funds to cover all or a large part of our upfront investment.
You can see at a glance that in my HMO example, this was not possible based on that particular project. 75% of £254,000, or £190,000, would probably be the best expected outcome, so leaving a chunk of cash invested into the deal. However, the original plan was to create a seventh bedroom and had that received planning approval, it would have left the highest valuation at £312,000 with a potential loan of £234,000 being realistic and so more or less covering my total initial cash investment.
Sadly, the planning department turned down the application and there is little chance of a successful appeal in this particular case. So, what would have been a near-fully recycled cash investment deal proved not to be as a result. C’est la vie as they say.
In reality, it is often the case that some money will need to be left in the deal. As you will have observed, by increasing the number of lettable rooms, whilst containing the upfront cash investment, a scenario could be created that gives rise to a fully cash recycling opportunity with HMO conversions. This does depend, as with last week’s discussion, on any associated cost of financing that are picked up.
The trick then, to achieve utopian fully cash-recycled HMO conversion, is to find the so-called ‘sweet-spot’ where the relationship between the gross rental income and total acquisition costs is harmonised for the project.
This will naturally lead us looking at low-cost property areas on the one hand, or alternatively as high revenue areas on the other. The reality is that it will be those mid-point locations, unless there are other factors at play, that will be most likely to generate the right balance between these two factors. Hunting those sweet-spot locations down is the tricky part.
As with our previous recycling discussion last time, I tend to work on a general principle of leaving in some of my cash in an HMO conversion project. I often find that by looking at the project over a 3-year time horizon, we are more likely to arrive at a position where we can call it fully cash-neutral. This would probably be the safest interpretation that I would give.
However, to achieve the Holy Grail outcome of fully recycling our cash from an HMO conversion, we really would need the perfect mix of location, local yield factors, controlled acquisition costs, maximised revenues…and both a supportive lender and valuer that recognises our business case.
So, in conclusion, it’s a ‘maybe’ from me on this one BUT it can be achieved under the right conditions. The real challenge with this method is that there is a lot more outside of our direct control and influence. We are still very much reliant on a third-party looking at us and our project in the most favourable light for it to succeed.
I have so far here spoken about one specific method of changing the investment valuation method, that from a residential valuation to a commercial one with an HMO conversion of a traditional house.
There are other ways, to achieve an alternative valuation result in property, which I won’t dwell upon right now but for reference can include:
Converting office, retail or other commercial premises into residential accommodation. Sometimes a former corner shop or disused office block is worth more as a house or flats than as the existing usage.
Similarly, the idea of changing a residential property to a commercial one could be extended to include hotels and guest houses for example.
The point being, that if we have an open mind when looking at property, we can start to see different possibilities of how it could be used differently with a little imagination. There is value in having such an imagination for sure, so when you next look at an empty pub, office block or grubby garage block just think for a minute…what if…?
As for HMOs, a word of caution on this one for you. Make sure that you
- target areas and tenants best suited for your converted property and
- consider what the barriers to entry are for someone else doing exactly the same as you with the next door neighbour’s house
Or in other words…will the local market get saturated too easily?
There we have it then, another recycling myth busted…perhaps not quite as emphatically as last time. However, what I hope comes over loud and clear is that to be successful in property investment, we need to not only be good with the numbers, we also need a good imagination, an eye for an opportunity, an appreciation of the art of the possible…and sometimes just a little bit of luck too!
That’s about all I wanted to say on the topic of recycling at this point in time, but there is so much more I could…which, no doubt will return to my top of mind thoughts again in the future J
Right now though, and in what is now time-honoured fashion, I just want to thank you very much for joining me on the show today and until next time on The Property Voice Podcast…it’s ciao ciao!